Business Cycles and Macroeconomic Policy in

Emerging Market Economies

Philip R. Lane∗IIIS and Economics Department, Trinity College Dublin and CEPR

Revised: January 2003

Abstract

This paper argues that significant structural differences exist between industrial

and emerging market economies. Cyclical fluctuations have been more extreme for the

latter group and exacerbated by inappropriately procyclical macroeconomic policies.

However, we argue that effective stabilization policies remain feasible for the emerging

market economies, so long as these invest in developing a robust domestic institutional

infrastructure.

∗Prepared for the Council on Foreign Relations / International Finance conference on “Stabiliz-

ing the Economy: What Roles for Fiscal and Monetary Policy?”, July 11 2002. I thank Rich

Clarida, Benn Steil and an anonymous referee for comments. Email: plane@tcd.ie. Homepage:

http://www.economics.tcd.ie/plane. Tel.: 353-1-6082259. Fax: 353-1-6772503. This work is part of a

research network on ‘The Analysis of International Capital Markets: Understanding Europe’s Role in the

Global Economy’, funded by the European Commission under the Research Training Network Programme

(Contract No. HPRN-CT-1999-00067).

1 Introduction

Understanding business cycles and their implications for optimal monetary and fiscal poli-

cies remains a primary challenge for research economists. The slowdown in the industrial

countries in 2001-2002 has prompted a renewed discussion about the appropriate policy

response to signs of impending recession. For the emerging market economies, a similar

debate also rolls on but is augmented by several additional factors that are not central to

the contemporary experience of the industrial countries. Among these are: the risks of

full-blown crises; contagion; time-varying external credit constraints; the currency denom-

ination of liabilities; and domestic financial underdevelopment. Do these special features

render counter-cyclical macroeconomic policy redundant or even counter-productive? Since

economic fluctuations are typically larger and more persistent for these countries relative

to the industrial nations, a lack of effective stabilization tools is especially costly. In this

paper, we critically review the current state of play regarding the interaction of business cy-

cles and macroeconomic policy in emerging market economies. In addition, we outline some

proposals for reform that may lead to improved stabilization performance in the future.

The structure of the rest of the paper is as follows. In section 2, we provide an empir-

ical characterization of some key stylized facts concerning the structure of industrial and

emerging market economies and their cyclical performance. Section 3 analyses the chal-

lenges faced by emerging market economies in implementing optimal monetary, exchange

rate and fiscal stabilization policies. We turn to proposals for reform in section 4. Section

5 offers some concluding comments.

2 Empirical Evidence on Business Cycles and Macro-

economic Policy

To provide a factual context for the discussion, we present in this section some empirical

evidence on cyclical macroeconomic behavior for a panel of industrial, East Asian and Latin

American and Caribbean countries. The 46 countries are listed in Table 1 and consist of

1

22 industrial countries, 5 East Asian countries and 19 Latin American and Caribbean

countries.1

We begin in Table 2 by examining some potential determinants of cross-sectional varia-

tion in output volatility across countries.2 It is well known that output volatility is inversely

correlated with the level of development and we include output per capita as a regressor in

each specification in columns (1)-(5) of Table 2.3 It is also plausible that smaller countries

may face higher volatility, since the scope for sectoral and regional diversification is more

limited. In similar fashion, countries that have high trade volumes may be more vulnerable

to external shocks, as may countries with volatile terms of trade. We also consider the

role of domestic financial development – a shallow financial system may exacerbate output

fluctuations through a variety of mechanisms. Finally, countries with large net external

liabilities may also be more volatile, if balance sheet channels act to magnify the impact of

cyclical shocks.

The results in Table 2 confirm a strong inverse relation between output per capita and

volatility, even controlling for other factors. Indeed, the simple regression in column (2)

explains 50 percent of the variation in output volatility. There is also support for the notion

that smaller countries are more volatile. However, the evidence here is that trade openness

reduces volatility, in contrast to what might be expected. Finally, there is weaker evidence

that terms of trade volatility contributes to output volatility but there is no cross-sectional

relation between volatility and domestic financial depth or the net foreign asset position.4

These findings help to explain why output volatility is so much different in emerging

markets as compared to the industrial nations. Table 3 shows the group variation in the

1Several interesting countries (eg Hong Kong and Singapore) are excluded from the sample due to the

lack of some key data. Most of sub-Saharan Africa is largely isolated from international capital markets

and so these countries face a different macroeconomic environment (Honohan and Lane 2001).2We also ran the same regressions for consumption volatility: the results were very similar.3See also Kraay and Ventura (2000) on this correlation.4That financial depth and the net foreign asset position are unimportant in this basic cross-sectional

specification does not rule out more subtle non-linear effects or an important role in explaining time-series

dynamics. Exploring these other mechanisms is deferred to future research.

2

explanatory variables employed in Table 2.5 East Asia and the Latin American/Caribbean

nations are far poorer than the industrial countries, have much more volatile terms of

trade and are less financially developed. Latin America in particular is also characterized

by low trade volumes and relatively small country size. Another clear difference is that

the emerging market economies carry significant net foreign liability positions, whereas the

typical industrial country is close to external balance.6

In addition, these groups vary not only in the amplitude of fluctuations but also in the

cyclical comovement of key macroeconomic variables with output. As a simple and concise

way to capture cyclical patterns, Table 4 reports results for the key coefficients from panel

regressions of the form

D(Xit) = αi+φt+β1 ∗ IND ∗CY Cit+β2 ∗EASIA∗CY Cit+β3 ∗LAC ∗CY Cit+εit (1)

where Xit denotes the macroeconomic variable of interest, CY Cit is the growth rate of

output and IND,EASIA and LAC are 0-1 group dummies.7 In row (1), we see that the

savings rate is appropriately procyclical in all groups but that it is far more responsive (by

a factor of 2.8) for the industrial countries than for the LAC group, with the EASIA group

in the middle.8 Put differently, output volatility differentials between the industrial and

emerging market nations are further magnified with respect to the variation in consumption

volatility across the groups.

We consider the cyclical behavior of the current account surplus in row (2) of Table 4.

The current account surplus is countercyclical for all groups, with the cyclical sensitivity

being substantially larger for the EASIA group. Although a procyclical current account

may be helpful in accumulating a buffer stock of net foreign assets during good times, the5All the data are averaged over 1975-2000.6Emerging markets also typically have riskier balance sheets in that external liabilities are more heavily

tilted towards debt rather than equity instruments (Lane and Milesi-Ferretti 2001).7It makes little difference if we employ other measures of the cyclical component of output, such as the

Hodrick-Prescott or band-pass filters. Allowing for asymmetrical responses to expansions versus contrac-

tions also does not substantially alter the findings.8If we allow for an asymmetry between output expansions and contractions, a notable feature is the

LAC group fail to increase the savings rate during recessions. See also Lane and Tornell (1998).

3

countercyclical pattern is well explained by the procyclical nature of investment spending.

Taken in conjunction with the savings equation in row (1), the similar coefficients for the

IND and LAC groups hide a different pattern: investment spending is much more procyclical

in the industrial countries than in the Latin American/Caribbean region but compensated

by a more procyclical pattern in savings.

We turn to fiscal policy indicators in rows (3)-(4) of Table 4. Row (3) shows that

the fiscal surplus is significantly procyclical in the IND and EASIA groups (and is more

procyclical in the former group) but that the LAC group fails to engage in budgetary

smoothing. Since row (4) shows that the difference does not come from the cyclical behavior

of the tax ratio, it seems that the IND group are better able to limit procyclicality in

government spending. Finally, the cyclical behavior of the real exchange rate is documented

in row (5) of Table 4. Its behavior is essentially acyclical for the panel of industrial countries

but is strongly procyclical for the emerging market groups: real appreciations occur during

booms and depreciations during contractions.9 This pattern means that the external value

of domestic output is even more procyclical than when deflated by the domestic price level.

In summary, this brief empirical review shows that the emerging market economies have

been structurally more exposed to business cycles than are the industrial nations. In addi-

tion, it seems that they also have coped less well in smoothing the impact of fluctuations.

In the next section, we critically analyze role of macroeconomic policy over the business

cycles for these countries.

3 Macroeconomic Policy in Industrial and Emerging

Market Economies

In this section, we review the domestic and external factors that contribute to procyclical

pressures on macroeconomic policies in emerging market economies. We first discuss mon-

9We do not address the causal mechanisms behind the correlation of output growth and the real exchange

rate.

4

etary and exchange rate strategies in responding to cyclical fluctuations, before turning to

the role of fiscal instruments in stabilization policy.

3.1 Monetary and Exchange Rate Policies as Stabilization De-

vices

The traditional Mundell-Fleming model has it that flexible exchange rates are desirable if

prices or wages are sticky and the economy is primarily disturbed by real shocks. In con-

trast, a fixed exchange rate system is superior if nominal shocks predominate. Benchmark

models in the more recent “‘new open economy macroeconomics” style also largely accord

with these broad findings. As a prelude, it is also worth emphasizing that the objective of

optimal macroeconomic policy is not to suppress all output fluctuations.10 For instance,

the economy should adjust to even temporary productivity or terms of trade shocks –

however, in the presence of nominal rigidities, efficient adjustment requires policy activism

rather than an acyclical stance. Product or factor market distortions may also justify

countercyclical interventions: for instance, an optimizing central bank will want to offset

“cost-push” shocks such as attempts by unions to raise wage premia.

However, several features are missing from these standard models that may be required

to understand business cycles in emerging market economies. In particular, there is a

substantial recent body of work that points to the importance of financial factors in under-

standing exchange rates in emerging market economies. Two main factors are highlighted

in this literature: (a) the presence of substantial foreign-currency debt means that exchange

rate movements lead to variation in the net worth of investors; and (b) credit market fric-

tions mean that investment may be constrained by the quality of the balance sheet.11 For

10Lucas (2003) provides an overview of the literature that emphasizes that optimal stabilization policy

in industrial countries would deliver only small welfare gains.11Of course, incorporating balance sheet effects is also helpful in understanding business cycles in the

advanced economies (Bernanke et al 1999). However, a lower level of financial development means that

such considerations are more important for the emerging market economies. Moreover, liabilities are largely

denominated in domestic currency for the industrial countries.

5

extreme cases (e.g. a very high debt-export ratio, a very weak real exchange rate and a

high sensitivity of investment to net worth), it is possible to construct multiple equilibria

scenarios in which self-fulfilling shifts in expectations can move an economy from prosperity

to a crisis (Aghion et al 2001, Velasco 2001). Moreover, in such extreme circumstances,

exchange rate devaluations are not helpful since the negative impact of the increase in the

burden of foreign-currency debt dominates all other effects.

Although such crisis situations are all too familiar, the mere facts that external-currency

debt exists and there are binding financial constraints do not mean that exchange rate

flexibility is generally undesirable. Rather, a number of authors have shown that, except

in the extreme situations outlined above, these features actually reinforce the need for a

countercyclical monetary policy in responding to shocks (Cespedes et al 2001, Gertler et al

2001, Devereux and Lane 2001, Velasco 2001). Although depreciation does raise the real

burden of foreign-currency debt, this is typically outweighed by the fact that (in addition to

its regular Keynesian effects) stimulating domestic output raises profits, which improves the

net worth of investors and relaxes credit constraints. Furthermore, expansionary monetary

policy improves domestic liquidity, which can partially compensate for a shallow domestic

financial sector and a deterioration in access to external capital markets (Caballero 2002).

In numerical simulations in which credit constraints and foreign-currency debt levels are

set at empirically reasonable levels, Devereux and Lane (2001) find that the presence of

financial constraints typically does increase the magnitude of business cycle fluctuations

but does not alter the relative ranking of alternative monetary and exchange rate regimes.12

However, there are other circumstances that also may favor an exchange rate peg or

at least limiting the scale of exchange rate movements. Devereux and Lane (2002) and

Christiano et al (2002) emphasize that exchange rate movements can be especially costly

if imported intermediates are important in domestic production and is financed by foreign-

currency working capital. Under these circumstances, depreciation depresses output by

12Broda (2001) provides econometric panel-VAR evidence for developing countries that adjustment to

terms of trade shocks is facilitated by a floating exchange rate. Hoffmann (2002) conducts a similar analysis

for shocks to world interest rates and world output.

6

directly increasing production costs, rather than just operating on investment demand.

Cavallo et al (2002) highlight another cost to floating: if there is a downward-sloping

demand schedule for domestic shares, devaluation and a binding financial constraint may

compel indebted domestic agents to recapitalize by selling equity at fire-sale prices, with a

depressing effect on long-run consumption levels.

Both types of friction serve to highlight that exchange rate flexibility is of limited

value for financially fragile economies. In their empirical work, Devereux and Lane (2002)

find that a greater dependence on foreign-currency debt loaned by a given creditor country

makes it more likely that a developing country will minimize bilateral exchange rate volatil-

ity vis-a-vis that currency. It is noteworthy that this effect becomes less important, the

greater is the depth of the domestic financial system, which suggests that the vulnerability

associated with foreign-currency debt is eroded by institutional development.

As is emphasized by Caballero (2002), Calvo and Reinhart (2002) and Mendoza (2002),

exchange rate depreciation further loses its potency if the monetary authority lacks credi-

bility. Under such circumstances, even a temporary monetary relaxation may be perceived

as heralding a persistent switch to a loose money regime, with a negative impact on con-

fidence and an increase in the risk premium demanded by foreign investors. This is really

a two-step hypothesis. First, can emerging market economies feasibly develop credible

domestic monetary institutions? Second, are the international capital markets sufficiently

discriminating to reward those countries that succeed in this endeavour? If either question

is answered in the negative, it may be economic for these countries to take the alternative

course of importing credibility by surrendering monetary independence via dollarization or

euroization. Related to the latter, the widespread withdrawal from emerging markets in

the wake of the 1998 Russian default has been taken by some experts to signify that even

well-behaved individual countries are vulnerable to a shift in investor sentiment towards

an entire asset class.

Drawing on his joint work with Guillermo Calvo, Mendoza (2002) lays out several rea-

sons why such rational contagion may be possible. Among these are (a) the entry of many

7

emerging nations into the international capital markets means that a diversified investor

has little reason to pay fixed costs to acquire information about individual countries; (b)

the reward system for institutional investors means that herding is a reasonable strategy,

since it is imperative to avoid under-performance relative to the market benchmark; and (c)

the tracking of large informed investors that specialize in emerging markets mean that idio-

syncratic shocks to these traders (eg margin calls on specific positions) can be interpreted

by the broader market as a negative signal regarding the entire asset class. However, the

discriminating response of the capital markets to the Argentina crisis suggest that conta-

gion is not inevitable and that country-specific characteristics do indeed matter for market

access.13

3.2 Fiscal Policy over the Cycle

We have focused our attention on the appropriate monetary and exchange rate strategies

for emerging market economies. Is there a role for a countercyclical fiscal policy? In terms

of timeliness and flexibility, we know that fiscal policy is at a severe disadvantage as com-

pared to monetary interventions. We also understand much less about the effectiveness and

transmission mechanism for fiscal policy (Perotti 2002). At one level, some fiscal stabiliza-

tion is achieved via the operation of automatic stabilizers. However, this is less likely to be

effective for developing countries that lack the extensive social insurance and income tax

systems that characterize the industrial nations.14 In related fashion, to the extent that

the government sector is also smaller as a proportion of total output, it is also the case

that aggregate output in emerging economies is more exposed to market fluctuations.15

Moreover, the history of fiscal policy in both industrial and developing countries is that

13See Hausmann and Velasco (2002) for a review of the Argentinian crisis.14Of course, the upside of limited automatic stabilizers is that the output response to positive productivity

innovations is less inhibited.15Gali (1994) and Fatas and Mihov (2001) document an inverse relation between government size and

output volatility. Of course, its impact on stabilization policy is not the primary criterion by which to

judge the appropriate size of government for a given country.

8

it has often been procyclical in nature (Gavin and Perotti 1997, Talvi and Vegh 2000, Lane

1998, Lane 2002b), with disproportionate spending increases combined with tax reductions

during expansions leaving little slack to cope with downturns. Procyclical tendencies are

likely to be most pronounced in countries characterized by political systems with multiple

fiscal veto points and where output volatility is higher (Lane 2002b, Stein et al 1999, Talvi

and Vegh 2000). The former can be rationalized by the voracity effect modelled by Lane

and Tornell (1998) and Tornell and Lane (1999): if there are multiple actors with access to

the fiscal process, the intensity of appropriative activity rises with the output growth rate.16

The latter is highlighted by Talvi and Vegh (2000) and is based on the proposition that

the greater is the amplitude of the cycle, the larger is the budget surplus that should be

run during output expansions. Since the political feasibility of running a surplus is sharply

declining in its magnitude, a country experiencing a large boom may opt to cut taxes

and/or raise spending, even if the tax-smoothing principle indicates that a large surplus

should be accumulated.

A basic problem in determining the appropriate fiscal stance is assessing the trend for

potential output. Clearly, this is a problem for even the most advanced economies but

it is exacerbated for developing countries for several reasons. First, potential output for

these economies is largely determined by their ability to adopt new technologies invented

elsewhere and accumulate capital. Both drivers are highly variable in an open economy,

since we know that growth miracles can occur if the institutional and policy structures are

correct but that stagnation and sustained capital flight are also feasible outcomes. In such

an environment in which countries are attempting to undertake various structural reform

and modernization programs, it is very difficult to assess whether a given output movement

16In general, the common pool problem leads to fiscal indiscipline. The voracity effect model shows how

the fiscal externality problem dynamically varies with the growth rate of the economy. Of course, the

common pool problem may also aggravate the difficulty of fiscal adjustment to downturns, for the “war

of attrition” reasons highlighted by Alesina and Drazan (1991). It is also worth remarking that multiple

fiscal veto points may make the political system more stable (Henisz 2000). It follows that a trade-off may

exist between fiscal predictability and the capacity to engage in discretionary countercyclical fiscal policy.

9

is permanent in nature or will be reversed at a later date. Excessive optimism concerning

prospects for output growth may lead to a fiscal relaxation that will have to be reversed

at a later date. Moreover, it is precisely negative information about the economy that will

induce the fiscal adjustment, such that the correction may take place just as the economy

is already slowing down.

These dynamics represent another manifestation of fiscal procyclicality, with a recession

precipitating a budgetary correction. If an unsustainable fiscal position is the source of the

downturn or is an important aggravating factor, a fiscal contraction is surely part of the

appropriate remedy in order to avoid a spiralling debt-export ratio and rising interest rate

premium. However, it is increasingly accepted that there is a low likelihood of an “expan-

sionary fiscal contraction” scenario, whereby the fiscal reform in itself generates a sharp

recovery in output (Giavazzi and Pagano 1990). Rather, it is desirable from a stabilization

perspective that an easing of the monetary stance accompany a fiscal contraction.

Even in regard to the original case studies cited by this literature, there has been

considerable revisionism. For instance, in the case of Ireland, the consensus view now is

that the fact that output grew quickly in the wake of the 1987 fiscal reform can be better

explained by a mix of a fortuitous contemporaneous boom in its major export markets plus

a substantial exchange rate devaluation in the summer of 1986 (Honohan and Walsh 2002).

Rather, it is desirable from a stabilization perspective that an easing of the monetary

stance accompany a fiscal contraction. It is also preferable that a fiscal correction be oppor-

tunistically timed to coincide with an upswing in the economy but this tactic is only feasible

if the long-term fiscal position is sustainable, thereby allowing the government some flexi-

bility in formulating a fiscal correction strategy. Finally, the findings of Alesina and Perotti

(1995) for the OECD reinforce the important point that the confidence-building element

of a fiscal reform relies on it being based on sustainable reductions in government spending

rather than increases in taxation. However, it is not clear that the same result would apply

for those developing countries for which the basic fiscal problem is an inadequate tax base.

A final source of fiscal procyclicality lies in the intrinsic dynamics of government debt.

10

Clearly, the primary surplus required to stabilize the debt-output ratio is increasing in

the interest rate paid on the debt and decreasing in the growth rate. Since the country

risk premium component of the interest rate is itself also inversely related to the growth

rate, a given budget balance is associated with a faster rise in the debt-output ratio during

slowdowns as compared to expansions. If the debt is denominated in foreign-currency, an

additional factor is that a real depreciation raises the burden of debt in terms of domestic

output, which Table 4 indicates is also most likely to occur during downturns.

From this discussion, it is evident that governments in emerging market economies face

a major challenge in ensuring that fiscal policy is not exacerbating cyclical fluctuations, let

alone acting as a stabilization instrument. In the next section, we turn to proposals for

reform that may improve their capacity to run counter-cyclical macroeconomic policies in

emerging market economies.

4 Proposals for Reform

Can stabilization policies in emerging market economies be improved? In this section, we

discuss some reforms that can combat the forces that generate procyclical pressures on

policy formation. A general theme behind these reform proposals is that embedding policy

decisions in a formal institutional framework can do much to reduce uncertainty about

medium-term economic prospects, thereby reducing the risk of policy-induced volatility.

First, monetary stability remains a paramount target. Except in rare cases, dollariza-

tion or euroization is unlikely to be an optimal strategy in pursuit of this goal. In general,

this option should only be entertained for very small countries or if the domestic institu-

tional infrastructure is deemed beyond repair. Dornbusch and Giavazzi (1998) advocate

euroization for the European accession countries. However, that is a substantially different

debate, since the terminal goal for these countries is membership of the eurozone. As such,

unilateral euroization is just a transitional stage towards full membership of the European

monetary union. For Latin America, the option of membership of a commonly-managed

currency zone including the United States is quite remote.

11

It should be recognized that such a policy works best if domestic price and wage setters

adapt flexibly to the elimination of the devaluation option: however, the same weaknesses

that prevent domestic institution building may also make less likely such responsiveness in

labor and product markets. Moreover, if the option to devalue the nominal exchange rate

is eliminated, shocks that require significant real depreciation can only be accommodated

via price deflation (Cespedes et al 2001). However, a sustained period of deflation is costly

in that it impairs the ability of indebted firms and governments to recover from negative

disturbances. Reinhart and Rogoff (2002) document that deflations are indeed a regular

occurrence among members of a currency union: for instance, they note that members of

the CFA zone experienced deflation about 28 percent of the time during 1970-2001.

Rather, for the vast majority of emerging market economies, the preferred route to

monetary stability is to retain some degree of monetary independence and develop a robust

and transparent framework to guide interest rate decisions. In line with recent developments

in the industrial nations, the most obvious candidate is to adopt an inflation targeting

approach in setting monetary policy.17 An inflation target can provide the medium-term

anchor that assures investors that price shocks will be met by an aggressive policy response.

Of course, credible pursuit of an inflation target requires a capable and autonomous central

bank that is demonstrably committed to medium-term price stability. Although the process

of establishing a credible inflation target may involve a prolonged period of temporarily high

real interest rates, the payoff will be a improved monetary climate. Central to improved

stabilization performance is that an inflation target that anchors medium-term expectations

would permit the central bank to smooth cyclical shocks without inducing countervailing

shifts in long-term interest rates.

Although the advantages of inflation targeting are by now well understood, there are

still a number of outstanding issues in terms of the execution of monetary policy. For open

economies, the selection of the appropriate target price index is a substantive issue. In

general, an optimizing central bank should target a price index that reflects those sectors

17See Mishkin and Savastano (2002) for an analysis of the recent implementation of inflation targeting

in a number of developing countries.

12

in the economy that exhibit nominal rigidities (Clarida et al 2001). One implication is that

if the rate of pass through is rapid from the exchange rate to the retail prices of imported

goods, it may make sense to target just a bundle of domestically-produced goods. However,

if pass through is low, the overall CPI index may be a more reasonable target (Devereux

and Lane 2001). As average inflation rates fall for the emerging market economies, the

empirical evdience is that the degree of pass through also declines: this further improves

the effectiveness of monetary policy in adjusting to shocks.18

In a similar spirit, a formal medium-term framework for the conduct of fiscal policy is

also highly desirable in order to insulate it from the pressures that generate procyclical-

ity. A number of commentators have recommended the establishment of an independent

Fiscal Policy Council (FPC) that would each year set a deficit limit in order to ensure a

sustainable medium-term debt level.19 Politicians would have to work within that deficit

limit in taking decisions on public expenditure and taxation. A FPC may be especially

useful in political systems that are characterized by high fragmentation, polarization and

frequent electoral turnover, since these factors are important contributors to procyclical

fiscal behavior. Enshrining the role of a FPC in legislation would be more effective than

informal procedures that are more easily subject to revision. In general, a FPC has a sim-

ilar motivation to the EU Stability and Growth Pact but is a more flexible concept that

would allow room for warranted counter-cyclical fiscal management.

A FPC system promises to offer much improved fiscal stability. However, there are

many other aspects of fiscal policy in need of reform. Structural innovations to expand

18We also note that policymakers in emerging market economies are even more afflicted by the presence

of uncertainty than their counterparts in the industrial nations (Lane 2002a). Although the classic result

is that parameter uncertainty should induce caution in policymaking, a large recent literature finds that

other forms of uncertainty should call forth a more aggressive stabilization policy (see Lane 2002a for a

review).19See the proposals by Eichengreen et al (1999) and Wyplosz (2002) and the commentaries by Perry

(2002) and De Gregorio (2002). Annett (2002) and von Hagen (2002) provide general surveys of the

literature on fiscal procedures. Fatas and Mihov (2002) provide some recent empirical evidence on the

effectiveness of institutional restrictions on fiscal policy.

13

the tax base and improve compliance would be helpful on the revenue side. For federal

systems, it is also clear that common pool problems between the central and provincial

governments must be resolved by addressing free-rider incentive problems.

Although reform of domestic monetary and fiscal institutions promises the largest payoff

in terms of improved stabilization policies, policy initiatives to address imported instability

from the international capital markets may also be useful. Of course, domestic reform in

itself will be rewarded by a more benign attitude on the part of international investors.

However, there still remains exposure to externally-generated capital market shocks. As is

elaborated by Caballero (2002b, 2003), part of the solution can be found in exploiting the

financial engineering opportunities that are available in contemporary financial markets.

Since the cyclical shocks facing emerging market economies are correlated with external

financial indicators (e.g. commodity prices, the high-yield spread in corporate debt mar-

kets), it should be possible to design contingent-claim securities that better insulate these

countries from external disturbances. Since it is well understood that externality effects

may inhibit the establishment of new financial markets, this may require intervention by

the international financial institutions to support the trading of such contingent-payoff

securities.20

As such, the current Sovereign Debt Restructuring Mechanism (SDRM) initiative that

is intended to improve the resolution of crises may be but the first step in a deeper process

of reconfiguring the international capital market environment that is faced by emerging

market economies. Indeed, improving ex-ante risk sharing opportunities would generate

more widespread gains than simply focusing on initiatives to reduce the costs of ex-post

crises. Of course, there is also scope for financial contracts that specify a payoff that is

conditional on domestic macroeconomic performance: however, moral hazard means that

the introduction of such securities would be much more challenging.21

Clearly, these individual reforms have interaction effects but the good news is that

these are largely mutually reinforcing. Medium-term monetary and fiscal stability are

20See Allen and Gale (1994) on the frictions that lead to missing financial markets.21See also Shiller (1993) and Borensztein and Mauro (2002).

14

complementary forces; domestic stability is enhanced by greater insulation from external

shocks; and the default risk on even contingent-claim securities is enhanced by internal

reforms that ensure debt sustainability. Finally, these reforms must be supported by a

sound and well-regulated banking system. In this regard, it is important that the banking

sectors in these countries are held to higher standards that are less exposed to procyclical

forces than are the mininum requirements laid out in the Basel II accord. Of course, in

the opposite direction, improved macroeconomic stability also greatly reduces the risk of

financial and banking crises.

5 Conclusions

The empirical evidence in this paper confirms that emerging market economies have ex-

perienced much more volatile output and income fluctuations and that these have been

further exacerbated by procyclical policies. We have described the domestic and external

constraints that contribute to these patterns. However, we have also outlined institutional

reforms in the conduct of monetary and fiscal policies that can do much to improve the

capacity to stabilize cyclical fluctuations. Although the case for inflation targeting is by

now widely accepted and it is being adopted by an increasing number of countries, rela-

tively less progress has been made in designing and implementing new fiscal procedures.

New forms of international financial engineering that may also help to stabilize emerging

markets are at an even earlier stage of development. Further research on all these fronts is

warranted.

Establishing a stable macroeconomic environment is but a first step in developing a high-

quality overall domestic institutional infrastructure.22 However, institutional innovation in

the macroeconomic policy sphere may provide the foundations for the difficult process of

implementing the long-term structural reforms that are required for the full development

of the economic and social potential of these countries.

22See Navia and Velasco (2002) on the political economy of ‘second-generation’ reforms.

15

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21

Table 1: Country List

United States Norway MexicoCanada Portugal NicaraguaAustralia Spain PanamaNew Zealand Sweden ParaguayJapan Switzerland PeruAustria United Kingdom Trinidad&TobagoBelgium Argentina UruguayDenmark Bolivia VenezuelaFinland Brazil JamaicaFrance Chile IndonesiaGermany Colombia KoreaGreece Costa Rica MalaysiaIceland Ecuador PhilippinesIreland El Salvador ThailandItaly GuatemalaNetherlands Honduras

22

Table 2: Determinants of Output Volatility

(1) (2) (3) (4) (5) (6)

constant 10.5 13.0 17.2 16.1 15.7 14.7(7.76)*** (6.22)*** (4.76)*** (4.31)*** (4.02)*** (3.19)***

GDP-PC -0.83 -0.82 -0.82 -0.65 -0.63 -0.63(5.86)*** (5.97)*** (5.85)*** (3.64)*** (2.5)** (2.02)*

Size -0.15 -0.27 -0.26 -0.25 -0.20(2.07)** (2.93)*** (2.91)*** (2.5)** (1.86)*

Trade -0.61 -0.84 -0.83 -0.72(1.41) (1.98)* (2.13)** (1.85)*

Vol(TT) 0.19 0.19 0.12(1.7)* (1.68) (0.97)

Fin Depth -0.11 -0.19(0.22) (0.37)

NFA -0.0013(0.15)

R2 0.50 0.52 0.55 0.58 0.58 0.56

F-stat 44.1*** 23.5*** 17.05*** 14.26*** 11.14*** 7.52***N 46 46 46 46 46 43

Estimation is OLS, with robust t-statistics in parentheses. All variables are measured as

averages over 1975-2000. Output volatility is standard deviation of the growth rate of GDP;

GDP-PC is average output per capita in log form; Size is log of population; Trade is log of

(exports+imports)/output; Vol(TT) is standard deviation of the terms-of-trade, adjusted

for variation in trade openness; Fin Depth is ratio of private credit to GDP; NFA is net

foreign asset position. Data sources: Fin Depth is from Beck et al (2000) dataset; NFA

is from Lane and Milesi-Ferretti (2001, updated); all other variables are from The World

Bank’s World Development Indicators online database.

23

Table 3: Group Variation in Fundamental Characteristics

IND EASIA LAC

Vol(GDP) 2.1 4.2 4.2

Vol(TT) 1.4 4.2 3.4

GDP per capita 22402 2789 2712Trade 62.5 77.8 53.8Population 35.8 68.1 20.5Financial Depth 80.2 55.0 27.2Net Foreign Assets -1.3 -29.3 -43.3

See note to Table 2.

Table 4: Cyclical Patterns

IND EASIA LAC

(1) Savings Rate 0.28 0.19 0.10(4.19)*** (2.79)*** (3.25)***

(2) Current Account Surplus -0.33 -0.54 -0.30(4.19)*** (6.84)*** (7.94)***

(3) Fiscal Surplus 0.26 0.15 -0.04(3.87)*** (2.02)** (1.15)

(4) Tax Ratio -0.07 0.049 0.002(2.10)** (1.29) (0.11)

(5) Real Exchange Rate 0.08 1.05 0.54(0.35) (5.01)*** (4.95)***

Pooled estimation with country and time fixed effects. Data sources: Real exchange rate

data are from Lane and Milesi-Ferretti (2000, updated); all other variables are from The

World Bank’s World Development Indicators online database.

24